The past decade has been one of tremendous growth for both so-called socially responsible investing – which had its heyday in the late 1990s and is currently experiencing an upsurge in interest – and exchange-traded funds, arguably one of the biggest stories on Wall Street this decade. But the relationship between the two most ballyhooed investments in the market is suspicious at best. At first glance, the two should be the best of friends, with each having plenty to offer the other. But this synergistic harmony hasn’t happened.
“ETFs have grown well,” concedes Reggie Stanley, chief marketing officer at SRI firm Calvert, but this growth “hasn’t really done anything to lower the demand for mutual funds,” his firm’s forte. And for the most part, ETF providers say they are seeing little demand for socially responsible funds within their products.
But little demand doesn’t mean zero demand. ETF provider PowerShares Capital Management is one of two firms offering a socially conscious ETF, the WilderHill Clean Energy Portfolio. The other is Barclays GlobalInvestors’ iSharesKLD Select Social Index Fund. PowerShares has also recently licensed WilderHill’s second public index, the WilderHill New Energy Global Innovation Index, though no product based on it has yet been registered.
“We think there’s a great opportunity” in clean energy, says Bruce Bond, president of PowerShares, adding that “investors should have some of their energy allocation to that space.” But don’t expect a broad-based social index fund from PowerShares. “You won’t see us bring out just a general socially-responsible fund,” Bond says. Similarly, the SRI guys do not see ETFs as a main attraction, with Stanley saying the funds are “for people who are looking to fill out a specified, industry-specific component of their portfolios.”
The reticence within the ETF world to embrace SRI is puzzling. SRI groups and firms have promoted their investing style as being of increasing interest to the investing public, which, according to surveys, sees SRI as a vehicle for everything from saving the environment to saving corporate honchos from themselves. Yet while, according to Calvert, more than half of all non-SRI investors are “interested” in putting money with socially responsible funds, and almost 40% of investors consider themselves socially responsible, the share of investors in socially responsible investments range from 2% to 11%, depending on who you ask.
ETFs, meanwhile, seem to have the ability to turn just about any investment into gold for its sponsor. Robert Wilder, the creator of the WilderHill indices that PowerShares licenses, notes, “In a way, I’m surprised that the assets are growing so fast” in the WilderHill Clean Energy ETF. “We started with a $10 million creation unit, and, I thought, ‘Well, that’ll take a few months.’” It took less than a day, and now the year-old portfolio boasts over $360 million in assets, making it one of PowerShares’ largest offerings by assets under management. Similarly, the Barclays KLD ETF has garnered more than $120 million since it’s inception a little more than a year ago. It stands to reason that, if SRI proponents want a bigger slice, ETFs would be a quick and popular way to do it.
In general, ETFs have not, to date, shied away from more obscure investments, including a dizzying array of broad-based index funds and sub-sector offerings covering such specialized parts of the market as homebuilders, nanotechnology, networking and water resources. The three major players in the ETF industry, PowerShares, Barclays and State Street Global Advisors, have indicated their desires to offer investors a full array of products, and the one-upsmanship between them has been a boon for index providers who can’t seem to create new, innovative indices fast enough.
So why haven’t the two got it together?
Karl Cheng, a portfolio manager with Barclay’s KLD ETF, says institutional investors might be responsible for the distance kept between the two. The large institutional base that his firm and SSgA rely on may be wary of “the overall SRI style of investment,” due to their “fiduciary responsibility to their beneficiaries to gain the highest performance with the risk they are willing to budget.” The negative screens many SRI funds and indices use may strike institutional investors as overly restrictive.
But others say it may only be a matter of time, according to some players. “I think it’s likely that there will be more of them down the road,” Todd Larsen, a spokesman for the Social Investment Forum, posits. He argues that the appearance of the two SRI ETFs last year is par for the course for the SRI industry, in which, Larsen notes, “as things come online in the mainstream marketplace, they become available in the SRI marketplace.”
Larsen argues that SRI’s representation in both the mutual fund world and the ETF world is roughly proportional. According to the Investment Company Institute, in February, there was more than $9 trillion invested in about 8,000 mutual funds in the United States. By the SIF’s count, there were 201 SRI mutual funds with $179 billion in assets at the end of last year. That’s about 2% of the total mutual fund universe. Meanwhile, Morgan Stanley reports almost $320 billion was invested in 221 U.S. ETFs in January, with the two socially responsible offerings accounting for a bit more than 1%.
So Larsen’s proportionality thesis is not too farfetched, though other ETF offerings – Standard & Poor’s 500 Index-based products, for instance – vastly outpace similar traditional mutual funds. ETFs are growing faster than just about any other asset class, growing more than tenfold since 1999.
And there certainly isn’t an acute shortage of SRI indices for ETF firms to license. KLD Research & Analytics, which licenses its Select Social Index to BGI for its ETF, has four others, including the widely-known Domini 400 Social Index. Calvert produces its own indices, and even offers an index mutual fund, the Calvert Social Index Fund, which Stanley notes offers larger investors – in the form of the ironically named I share class – a fee capped at 21 basis points, well below most ETFs.
“There are several SRI index funds out there,” Larsen notes, meaning “there’s room for growth in that area.”
Part of the problem may lie in a differing vision of what makes a good investment. Calvert’s Stanley says his firm “believes very strongly in the benefits of active management,” something that ETFs cannot yet provide. “We do think there’s a place for more specific ETFs,” Stanley says, adding that Calvert is “constantly” evaluating whether it should get in the game. Larsen chalks it up to the “diversification of the kinds of [SRI] funds that are out there.”
The relatively conservative approach of SRI firms to new asset classes helps to explain their slow adoption of ETFs. Equally, there is some skepticism in the ETF community about SRI.
“We’re not bringing out SRI-types of products that we don’t feel make sense from an investor perspective,” Bond says. Asked to elaborate, he notes, as many others have, the nebulous nature of SRI’s definition. “When it’s not fairly tightly focused, it’s really hard to tell if it’s socially responsible.”
Paul Mazzilli, an ETF expert at Morgan Stanley, takes an even dimmer view. “If you look at the history of socially responsible funds,” he says, “they haven’t been very good performers.”
Indeed, while it overstates matters to say that SRI products are bad investments – in other words, investments in which you’ll lose your shirt – they have not returned, on average, as much as their less socially aware rivals. The Wall Street Journal has found that, on average, investors forfeit 30 basis points, annualized over 10 years, in return for upholding their principles. And, as Wilder says, much to PowerShares’ chagrin, no doubt, “I tell the world that this index can drop like a rock.”
The interest in the products is, however, undeniable: Calvert’s Stanley acknowledges that, “if you look at the dollars that are going into the two ETFs, they’re not insignificant. They’re meaningful.” Meaningful to the tune of being among the top 10 SRI offerings, in terms of asset inflows, he adds. That amount of money is going to be hard to ignore.
“Until now, the ETF market has been dominated by Barclays and State Street, and both companies realized that the biggest short-term opportunity for them was financial advisors,” David Jackson, editor of the blog ETF Investor and the Seeking Alpha blog network, says. “FAs build portfolios based on asset allocation, not ‘themes,’ and certainly not ‘emotional’ themes like socially responsible funds.”
Karl Cheng, a portfolio manager with Barclay’s KLD ETF, adds that the large institutional base that his firm and SSgA rely on may be wary of “the overall SRI style of investment,” due to their “fiduciary responsibility to their beneficiaries to gain the highest performance with the risk they are willing to budget.” The negative screens many SRI funds and indices use may strike institutional investors as overly restrictive.
“But,” Jackson notes, “as ETFs become more widely used by retail investors, specialty ETFs should become more popular.”
Wilder and PowerShares seem to be counting on it. About an ETF based on his global new energy index, Wilder says, “Will it attract a lot of buying? I do believe so. Given what we’ve seen with the clean energy index, you have to expect it to do well.” He, for one, sees the affinities between the two.
Cheng agrees: “The structure [of ETFs] is conducive for SRI, certainly in that it provides a vehicle for retail investors who are interested in pursuing a socially responsible investment.” And, he adds, the interest in SRI ETFs is not purely from the retail side. Over half of his fund is owned by a large institutional investor. Cheng declined to disclose the name of the investor.
According to SIF’s Larsen, others are starting to come around. “There are people looking at it,” he says. “There are funds that are going to come down the pike.” Both Bond and Cheng say they are open to new opportunities. And if down the road a WilderHill New Energy Global PowerShare proves as successful as its predecessors, it could help assuage the skeptics on both sides, as well as wary investors of both the retail and institutional variety.